Topic: Tax and Budget Policy

New at Cato Unbound: Alan Reynolds’ Income Distribution Heresies

In a speech yesterday, Federal Reserve Chairman Ben Bernanke worried that rising income inequality may make Joe and Joanne Lunchbox “less willing to accept the dynamism … so essential to economic progress,” which would be bad. ”Bernanke Warns of Economic Inequality,” Forbes’ headline tolls. 

Bernanke is evidently sold on what economists call the ”skill based technical change” hypothesis, which basically says that new technology has increased the productivity, and thus the wages, of high-skilled workers faster than it has for low-skilled workers. Bernanke sagely advises us not to look to globalization as the source of increasing inequality, and urges a broader diffusion of the kinds of skills that really pay off in today’s economy.

But is there actually something to be worried about? Is income inequality really widening at all? Are the incomes of the wealthiest increasing faster than those of the rest of us?

As it happens, those are the question of this month’s edition of Cato Unbound, “Interrogating Inequality,” which kicks off today!

It turns out these questions are a lot harder than they seem, and the answers turn on which set of government statistics — each with its own special biases — one consults. In this month’s lead essay, “Income Distribution Heresies,” Cato’s own Alan Reynolds — who set off a firestorm of controversy with a Wall Street Journal op-ed last month disputing the received wisdom about growing inequality — clarifies and refines his argument that massively increasing income inequality is an illusion. Replying to Reynolds, we’ll have the Brookings Institution’s Gary Burtless, University of Oregon economist and econ-blogger Mark Thoma, Cornell University inequality specialist Richard Burkhauser, and the Germano-Italian econo-duo Dirk Krueger and Fabrizio Perri, of the Universities of Pennsylvania and Minnesota (and the Minneapolis Fed), respectively.

So … is the specter of rising income inequality a statistical quirk or not? What’s really going on, income distribution-wise? Why not pay more attention to the wealth and consumption numbers, in any case? Only Cato Unbound readers will really be in the know.

Goldman Sachs Predicts Recession if Bush Tax Cuts Expire

The Congressional Budget Office predicts a budget surplus in 2012, but only because it assumes the Bush tax cuts expire in 2011 (a reasonable assumption) and that this will lead to a flood of new tax revenue (a very unreasonable assumption). A TCS Daily column by James Pethokoukis notes that this leads the Wall Street firm of Goldman Sachs to predict a recession in 2011:
Deficits are often used as reason for higher taxes, such as in 1993 and 1982. But to believe in higher taxes as sound economic policy in coming years, you also have to believe in the CBO’s cheery forecast that hundreds of billion of dollars in new taxes will have little or no effect on economic growth. Now you don’t have to be an acolyte of supply-side guru Arthur Laffer to find that sort of “static analysis” a little weird. Most Americans probably would. So, apparently, did the economic team at Goldman Sachs, the old employer of Robert Rubin, President Bill Clinton’s second treasury secretary. Thus the firm’s econ wonks decided to try and simulate the real-world effect of letting the Bush tax cuts expire at the end of 2010. Using the respected Washington University Macro Model, Goldman reset the tax code to its pre-Bush status, assumed all tax cuts expired, and watched how the economy reacted as 2011 began. What did the firm see? Well, in the first quarter of 2011 the economy dropped 3 percentage points below what it would have been otherwise. “Absent a tailwind to growth from some other source,” the analysis concludes, “this would almost surely mark the onset of a recession.”

The German “Brain Drain” Continues

While the tax competition debate usually focuses on capital flows, there is growing evidence that talented individuals are “voting with their feet” and leaving high-tax regimes. German and French taxpayers are among the most likely to emigrate, according to the New York Times, with Swtizerland and the United States being favorite destinations:

Benedikt Thoma recalls the moment he began to think seriously about leaving Germany. It was in 2004, at a New Year’s Day reception in nearby Frankfurt, and the guest speaker, a prominent politician, was lamenting the fact that every year thousands of educated Germans turn their backs on their homeland. …There has been a steady exodus over the years, but it has recently become Topic A in a land already saddled with one of the most rapidly aging and shrinking populations of any Western nation. With evidence that more professionals are leaving now than in past years, politicians and business executives warn about the loss of their country’s best and brightest. …The trigger for this latest bout of angst was the release last fall of new government statistics showing that 144,800 Germans emigrated in 2005, up from 109,500 in 2001. At the same time, only 128,100 Germans returned, a decline of nearly 50,000 from the year before. That made it the first year in nearly four decades that more people left than came home. Demographic experts also say the nature of the emigrants is changing. These are not just young unskilled workers like those who fled the economically blighted eastern part of Germany after the country was reunified in 1990 to work in restaurants in Austria or Switzerland. They are doctors, engineers, architects and scientists — just the sort of highly educated professionals that Germany needs to compete with economic up-and-comers like China and India. “It’s not a problem of numbers as much as brain drain,” said Reiner Klingholz, the director of the Berlin Institute for Population and Development. “What we desperately need in the near future are talented and qualified people to replace those who will retire in 15 to 20 years.” …Germany is not the only European country losing people. Nicolas Sarkozy, the conservative presidential candidate in France, recently held a rally in London, home to 300,000 French citizens living in Britain, urging them to return and “make France a great nation.” The number of French citizens living in Britain jumped 8.4 percent in 2005, according to government statistics. But the total number of French people living outside the country grew only 1.2 percent, or 15,300 people, roughly equivalent to Germany’s net loss of about 16,700 citizens. Caveats aside, there is plenty of anecdotal evidence that Germany has become less attractive for people in fields like medicine, academic research and engineering. Those who leave cite chronic unemployment, a rigid labor market, stifling bureaucracy, high taxes and the plodding economy — which, though better recently, still lags behind that of the United States. …While the European Union’s expansion has given Germans more options, their two favorite destinations are outside it: Switzerland and the United States.

Bush’s “Austere” Budget

“Bush Plan Reins in Domestic Spending” – Washington Post

“Bush budget to cut aid to Mich.” – Detroit News

Bush budget puts pinch on domestic spending” – Boston Globe

Reality check:

Federal Outlays from 2001 through 2006

Every year the headlines speak of budget cuts, and every year the federal budget rises. As I wrote two years ago:

There’s a conspiracy afoot to convince American taxpayers that President Bush has submitted a lean, mean budget for Fiscal Year 2006. The funny thing is, Democrats and Republicans are both in on it, and journalists are going along. A reality check is in order….

Democrats, Republicans, and journalists mostly agree that President Bush has submitted a lean, tight $2.57 trillion budget. Why? I think we have what dancers call a pas de deux going on here. Or maybe in honor of our Texas president and his aversion to all things French, we should just call it a Texas Two-Step: The president pretends to cut the budget, and Democrats pretend to believe him.

Both sets of politicians appeal to their bases that way. President Bush’s voters want to hear that he’s cutting the budget and saving tax dollars. The Democrats’ base of government employees and federal grant recipients want to see Democratic senators fighting budget cuts. When Kennedy and Clinton denounce Bush’s “devastating” budget cuts, their supporters become outraged at Bush. Meanwhile, Republican voters respond to such charges by becoming more supportive of Bush. They may have had some doubts about Bush’s commitment to fiscal conservatism, but the denunciations from Pelosi and her colleagues assuage those doubts.

Spending under President Bush has risen from $1.863 trillion in fiscal 2001 to a proposed $2.901 trillion in fiscal 2008. Not since Lyndon Johnson have we seen such rapid spending increases. But most of the responses to any new budget come from special interest groups–local governments, chiefs of police, Sallie Mae, AARP, veterans, environmentalists, health care providers, subsidized farmers–and they help to shape the perception that the budget is chopping programs.

Taxpayers would be better served if newspapers would run a nice clean graph–like the one above–with every budget story.

Some Perspective on the President’s Budget Request

The White House has been spinning reporters all day with the claim that the new budget holds non-defense spending down, and in some cases even cuts some domestic spending from 2006 budget levels. 

To test the claim, I’ve compiled below the proposed fiscal 2008 inflation-adjusted growth rates for spending in the non-defense Cabinet-level agencies compared to the 2006 budget:

Real Proposed Change in 2008 Non-Defense Cabinet-Level Agency Budget vs. 2006 Budget Level
   
Agriculture -9.2%
Commerce 5.9%
Education -40.2%
Energy 6.1%
Health and Human Services 8.5%
Housing and Urban Development -0.2%
Interior 10.8%
Justice -1.7%
Labor 15.6%
Transportation 6.3%
Treasury 7.7%
Veterans Affairs 13.8%
EPA -10.9%
Total
4.1%

All told, there are five agencies that receive a cut in real dollars: Agriculture, Education, HUD, Justice, and the Environmental Protection Agency. Yet even by the White House’s own numbers, all of these programs combined will still grow beyond the 2006 levels by 4 percentage points above inflation. 

Still, we need to wonder: What does this standard really tell us? 

Not much. The 2006 budget levels were already bloated after a six-year Republican spending spree. What’s actually interesting to see is how much these agencies would grow — after adjusting for inflation and assuming Congress rubber-stamps the president’s new budget — when compared to budget levels on the day Bush assumed office: 

Real Proposed Change in 2008 Non-Defense Cabinet-Level Agency Budget vs. 2001 Budget Level
   
Agriculture 8.0%
Commerce 16.8%
Education 36.2%
Energy 10.7%
Health and Human Services 35.6%
Housing and Urban Development 8.3%
Interior 12.0%
Justice 7.7%
Labor 8.8%
Transportation 12.4%
Treasury 11.7%
Veterans Affairs 52.7%
EPA -12.8%
Total
22.4%

To put it another way: Bush’s new budget still does next to nothing to strip away most of the massive budget increases in domestic programs he signed into law since 2001. It’s the fiscal equivalent of a recovering alcoholic patting himself on the back for merely drinking six beers a day instead of eight.

Rule-of-law and U.S. Competitiveness

Policies such as Sarbanes-Oxley are reducing America’s competitiveness, but an equally worrisome problem is the erosion of the rule-of-law.

Stability and equal treatment are among the characteristics of an advanced legal system. Unfortunately, America’s legal system is now riddled with uncertainty, since investors and companies have no way of predicting outcomes.

The New York Sun has a column noting how America’s justice system is now an obstacle rather than an inducement to international investment:

[T]he American share of global initial public offerings declined to 5% from 50% in the last five years. Foreign companies are being scared away in part, both reports conclude, by soaring costs of American law.

The highwater mark for securities lawsuits was reached in 2005, with over $9 billion in class action settlements. The zeal of American prosecutors in corporate scandals is also of a different order of magnitude. In 2004, government fines in America totalled $4.74 billion, over 100 times more than in Britain, which had a total of $40.48 million. Sarbanes-Oxley, the federal law that imposes higher accountability standards on corporate boards, has almost tripled auditing costs for small public companies.

Perhaps the most chilling parts of the Bloomberg-Schumer report are the surveys of foreign business leaders who suggest, overwhelmingly, that they no longer trust American law. For most of the last century, trust in American commercial and securities law was one of our greatest competitive advantages. Investors flocked to our markets because securities laws guaranteed transparency and honesty. American contract law was the gold standard for world business, in part because of a long tradition of judges rigidly applying guidelines of liability and damages.

Economist Douglass North received a Nobel prize in part for his work on the vital role of legal stability in economic prosperity. An “essential element of the concept of justice,” legal philosopher H.L.A. Hart observed, “is the principle of treating like cases alike.” That’s why law is the foundation of freedom — people know where they stand. They can act freely instead of looking over their shoulders all day long.

But that trust has now capsized. Companies are afraid that if a few employees out of thousands do something wrong — even if not material to the bottom line — the company faces the prospect of ruin. An indictment, not a conviction, could put a company out of business. Why roll the legal dice in America when legal systems in Britain and elsewhere focus on punishing the individual wrongdoer, not shooting everyone in sight?

It’s impossible to measure how much distrust of law has contributed to declining competitiveness. But the evidence is all around us. Just talk with foreign business leaders.

The main victims of this trend, however, are employees and their pension plans. Drying up of markets means that countless people lose job opportunities and that innovation moves offshore. Trust, once lost, is hard to regain.

Tort reforms limiting damages don’t get close to the heart of the problem. American justice has a deeper flaw — it no longer reliably distinguishes right from wrong. Instead, decisions are made on an ad hoc basis, jury by jury, without predictable boundaries.

Hong Kong to Lower Flat Tax?

Thanks to strong growth, which is in part due to a tax system that minimizes the burden on productive activity, Hong Kong leaders are considering reducing the flat tax to just 15 percent.

Tax-news.com reports:

Donald Tsang has pledged to cut Hong Kong’s individual and corporate income taxes if re-elected as the Special Administrative Region’s Chief Executive next month. Tsang officially announced that he would seek election to a second term of office last week and said that one of his key policies would be to return some of Hong Kong’s fiscal surplus back to the population through a “gradual” reduction in salary and profit taxes to 15%.